The role of the board

the needs of several different constituencies is a recipe for blurred accountability and poor performance.

What value does the board add?

When publicly quoted companies are taken private by private equity firms, most or all of the outside directors are normally replaced with people directly linked to the new owners. According to a recent US study, the boards of private equity-owned companies are fundamentally different from the public boards that are the focus of governance activists. ‘They are typically smaller and consist only of representatives of private equity owners whose explicit job is to help managers create and execute strategy; many directors fulfil both roles.’ As a result, according to this view, the board is far more involved in assisting the company.19

Does this imply that the conventional public company board in the UK, with its mix of inside and outside directors, adds little value? Do boards exist mainly to satisfy corporate governance codes and listing requirements?

A cynical view might be that the board is marginal to the real business of the company, that it is largely reactive rather than active, and that the executive team derives little that is useful from its deliberations. A more positive view is that a good board adds value in three main ways: it acts as a check on the executive team; it provides advice; and it improves the overall quality of the company’s decision-making. On the first, boards do this part of the job more effectively than they did fifteen years ago. Whether their influence is more positive than negative – it is easier to say no to a risky proposal than to understand it fully and support it – is open to question. On the second, there is not much doubt that an improvement has taken place. Because of the stringent criteria that are now applied to the appointment of outside directors, the skills and experience around the board table are more relevant and potentially more useful than used to be the case. The biggest uncertainty is over the third function: does the board improve the quality of decision-making?

The prevailing view among current Chairmen is that a well-managed board, made up of independent-minded people who work as a team, are committed to the success of the business and are knowledgeable about it, can make a valuable contribution.

Yet before accepting this favourable verdict, two reservations need to be stated. First, it is a mistake to exaggerate what boards can do. The composition and behaviour of boards are not the principal determinants of a company’s performance, and it is wrong to look to improved corporate governance as the key to raising the level of British industrial performance. In this context, one might question the assertion in the introduction to the Higgs Report that

19 Geoffrey Colvin and Ram Charan, ‘Lessons of Private Equity’, Fortune, 27 November 2006.

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effective boards will help in closing the productivity gap between the UK and its major competitors.20

Second, any assessment of the value of the British-style board has to take into account the difficulty of its task. Companies cannot be run by committee. Leadership has to be vested in the Chief Executive, and that person has to be given the authority and freedom to lead. Second-guessing on the part of the board is a recipe for confusion or inertia.

Companies can get into trouble for two main reasons: a single bad decision that throws the business seriously off course, and a slow decline that stems from deteriorating performance on the part of the Chief Executive and his team. In theory, the board should be able to prevent both eventualities, but there are many reasons why they do not do so. On the first, it is not easy for outside directors to reject proposals that are strongly supported by the Chief Executive and, probably, also the Chairman, as well as by external advisers.

Take, for example, a major acquisition designed to transform the fortunes of the company and take it into a new, high-growth market – perhaps a ‘bet-the- company’ decision. Boards can examine the costs, risks and potential benefits of such a deal in detail, but when the arguments are finely balanced, should the board overrule the Chief Executive or give him his head? Again, the board may be faced with a proposal to commit large funds to a new product at a time when neither the future market nor the manufacturing costs can be precisely assessed. The easy response might be to delay the decision until there is less uncertainty, but would the company then forgo its first-mover advantage?

Since the outside directors are less well informed about the details of these projects than the management team, they will need to be very certain of their ground if they are to turn them down. They also have to recognise that a risk-averse board which consistently restrains an ambitious Chief Executive is unlikely to add value.

A situation of slow decline presents problems that are hardly less difficult. To remove a Chief Executive when his performance is falling short of expectations requires the board to be convinced that the problems are the fault of that individual, and not due to circumstances outside his control. The factors causing the company to perform poorly may be complicated and hard to assess, particularly if they involve unexpected changes in technologies or markets. Moreover, dismissal will be a disruptive event, damaging morale within the company and causing uncertainty among investors, customers and suppliers.

Underlying these problems are the ambiguities which have been touched on earlier in this chapter. To whom are the non-executive directors responsible and, to the extent that they have multiple responsibilities, how should they be balanced? As several commentators have pointed out, a great deal of attention has been paid in recent years to making directors independent of management.

20DTI, Review of the Role and Effectiveness of Non-executive Directors, The Higgs Report, January 2003, p. 11.

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The role of the board

Much less attention has been paid to making them accountable to shareholders. While directors recognise that they are ultimately responsible to shareholders, in their relationship to the company their main loyalty is to the Chairman and the Chief Executive, and their instinct is to support them, not to stand in their way.

How do boards know whether or not they are doing a good job? Most companies now go through an annual self-evaluation process and this exercise has helped to identify where board processes could be improved, how meetings can be made more productive, and so on. The improvements that result from these exercises tend to be useful rather than fundamental, and this reflects uncertainty about the criteria that should be used to assess board effectiveness.

It is not difficult to draw up a list of board responsibilities which would be acceptable to most directors. How exactly are these responsibilities to be fulfilled, and which ones are the more important? Boards vary in the way they approach their task; the differences may be due to the personalities of the Chairman and Chief Executive, to the particular stage which the company has reached or to the external market situation which it faces at the time.

A useful distinction has been made between the board as watchdog and the board as pilot. The former implies a strong focus on monitoring and oversight while the latter is much more active, gathering a great deal of information and involving itself directly in decisions.21 One can envisage a spectrum of board styles ranging from watchdog at one end to pilot at the other, and there is a strong case for boards thinking hard about where along that spectrum they want to be. The two American commentators quoted earlier, Colin Carter and Jay Lorsch, argue that each board must define the value it intends to provide. ‘It must explicitly choose the role it will play, and its choice must be informed by a good understanding of its company’s specific situation and its own capabilities and talents.’22

An appraisal of board performance should start with the recognition that all boards are not alike and that directors should decide for themselves what sort of board the company needs. The choice will be influenced by several factors, both internal and external: whether, for example, the Chief Executive is recently appointed or nearing retirement, or whether the external environment is turbulent or stable. Whatever the choice, it should be discussed and agreed by the directors, and their performance should be judged against the criteria which have been worked out.

Such an exercise, probing more deeply than the typical annual self-appraisal, does not necessarily make the task of the board easier. The fundamental appraisal which is suggested here would have the value of exposing these ambiguities to the scrutiny of the board as a whole. Moreover, individual directors,

21Ada Demb and F.-Friedrich Neubauer, The Corporate Board: Confronting the Paradoxes, Oxford: Oxford University Press, 1992, p. 55. These issues are also discussed in Carter and Lorsch, Back to the Drawing Board.

22Carter and Lorsch, Back to the Drawing Board, p. 61.

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many of whom often feel uneasy about whether they are making a significant contribution to the board, would find it easier to assess their own performance if it could be related to a set of agreed goals for the board as a whole.

Some unresolved questions

An effective board of directors is the central element in any properly functioning corporate governance system. Most of the corporate governance reforms that have taken place in the UK since Cadbury have been concerned with the role of the board, its composition and its mode of operation. That improvements have been made is not in doubt, but there is a danger of complacency about what has been achieved. It is true that the UK has not had its Enron or its Parmalat. Relations between boards of directors and investors are more balanced than, for example, in the US. But it does not follow that the UK has got everything right. There are legitimate questions to be asked about the British system. How should the responsibilities of the non-executive Chairman be defined, and what sort of person is best qualified to carry them out? Do non-executive directors have a sufficiently strong incentive to act on behalf of shareholders? What is the appropriate balance between independence and knowledge of the business?

The fact that these questions still need to be asked does not imply that the British system is seriously flawed. The point rather is that the issue of how to make boards work better needs continuous attention from practitioners, regulators and academics. The biggest challenge for researchers is to find a better way of measuring the performance of boards and the contribution they make, or fail to make, to the performance of the company. Even if definitive answers cannot be reached, the attempt must be made, if only to establish a more robust foundation for corporate governance reform.

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